Is curbing gold imports an effective measure?

The answer to both is yes. As per World Gold Council estimates,India is likely to import a whopping 615 tonnes of gold in the first half of 2013,compared to only 381 tonnes a year ago. Since India fulfils almost its entire requirement of gold through imports,this trend has led to worrisome levels of CAD.

Indias trade deficit jumped to more than 20 billion in May as gold and silver imports surged nearly 90 yoy in the month. Consequently,RBI has been taking steps to curb gold imports,such as hiking the import duty and imposing regulatory restrictions.

While this step may be desirable,it may not be necessarily effective. Alternatives for curtailing CAD a consumption-aided disaster such as reducing government expenditure exist and might be better. The crucial question is why the government remains hesitant to adopt these measures.

The finance minister appealed to the citizens to resist the temptation of buying gold. But why penalise the consumer for situations that have been partially created on account of governments own actions?

Indias 2012 gold demand was about 11 more than that of China and five times that of the US. So,curtailing demand will align Indias gold consumption with the global players. But as shown in figure 1,the value of gold imports in India has surged recently,despite the sharp rise in gold prices,indicating that our gold imports are relatively price inelastic.

It implies that while the demand for gold may have reduced with an increase in its price,the total expenditure on gold imports has increased. Thus,import bill has risen. In such a scenario,increase in gold import duty is unlikely to reduce CAD substantially.

The policymakers also need to appreciate that gold demand is largely driven by cultural factors,tax evasion and the need to acquire a safe and liquid instrument. Rising inflation has made purchase of gold more of an investment decision rather than a consumption decision.

Despite price rise,there are some limits beyond which the consumption of gold is not likely to be substituted by other forms of consumption. Also,Indians tend to accumulate gold over a period of time,thereby giving them considerable scope to vary the rate of purchase as the prices fluctuate.

In addition,rising incomes have resulted in enhanced purchases of gold. It is estimated that for every 1 increase in income,gold consumption increases by 1.5 implying high income elasticity. With a combination of price inelasticity and income elasticity,curbing gold imports through duty hikes as a means to check CAD remains questionable.

Instead,reducing the ballooning fiscal deficit of the government by curtailing subsidies and inefficient and non-productive expenditure seems a more desirable step. In India,government expenditure is not always prudent and has high systemic leakages. So,can regulation of government expenditure through a prudent fiscal policy also achieve a favourable trade account? If so,then it certainly seems to be a win-win policy.

Simple macroeconomic identity states that fiscal deficit equals trade deficit plus saving-investment deficit. If Indias fiscal deficit goes up,then either household savings must go up and/or private investment must decrease,or the trade deficit must go up. Studies have generally found evidence suggesting that fiscal expansion worsens the current account.

Estimates indicate that if government deficit-to-GDP ratio rises by 1 percentage point,the current account-to-GDP ratio worsens between 0.2 and 0.7 percentage points. There are three ways in which fiscal policy can affect the external account. The direct impact is through demand: fiscal expansion through a tax reduction or spending increase tends to increase demand for goods. Higher the import propensity of additional demand,greater will be the adverse effect on current account. Other impacts are through the real exchange rate and rising interest rates.

If increase in government spending is skewed towards home,it induces a real appreciation on account of either higher interest rates or inflationary tendencies that are often the result of expansionary fiscal policy. Additionally,capital inflows induce currency appreciation. Consequently,net exports fall,thus widening CAD.

This was one of the key findings of the 2012 Kelkar Committee on the Roadmap for Fiscal Consolidation,which was established to advice on medium-term fiscal consolidation. The committee observed that an increase in fiscal deficit will have to be balanced by either a reduction in private investment or an increase in CAD.

A corollary to this would be that a fall in fiscal deficit would be balanced by a fall in CAD or a fall in net private sector savings figure 2. For the period 2008-12,the increase in Indias fiscal deficit from 2.5 to 5.7 was accompanied by rising CAD from 1.3 to 4.2. However,the pre-2008 period has experienced falling fiscal deficit with rising CAD.

This is because during this period the private sectors investment rate outstripped its own savings rate,thereby narrowing its saving-investment gap. Higher private sector investment skewed towards import of capital goods and industry raw-materials contributed to the rise in CAD.

But post the financial crisis,subsidies as a percentage of GDP increased as the government sought to cushion the impact of a global slowdown and rising international commodity prices,which resulted in a worsening of the fiscal deficit situation.

It is well established that subsidies towards food,fuel and fertilisers constitute a large chunk of Indias fiscal deficit. Leakages in implementation and poor targeting make expenditure on subsidies even more debatable. The argument suggests the applicability of the Mundell-Fleming model,wherein government spending towards fuel,food and fertiliser results in rising interest rates,real exchange rate appreciation and worsening CAD.

An anomaly here is that despite rising subsidies,currency has depreciated,and yet current account balances have deteriorated. This is due to the fact that exports have been hit by the overall global slowdown while our import basket has been relatively insensitive to the real depreciation.

It is important for students of management and economics to realise that an obvious solution need not necessarily be the most optimum one. Effective economic and financial management necessitates one to explore all possible dimensions to a problem.

It can be argued that as CAD has been driven by excess consumptionconsumption-aided disasterit is necessary to introspect our policies and take corrective steps through concerted policy action. Amongst others,an important measure is to curtail the fiscal deficit. A cliché but a pertinent one is: big governments are not necessarily good governments.